Greek Deal Highlights Flaws in Default Swaps

By

Charles Forelle

Updated March 19, 2012 9:34 a.m. ET

LONDON—A group of financial-market players on Monday will determine that holders of $3.2 billion in Greek credit-default swaps will receive around $2.5 billion in compensation for Greece's debt restructuring—a payout that mirrors the loss that creditors suffered.

Greece looks to swap old bonds for new bonds as part of its bailout deal and UPS says a deal to take-over TNT Express has been reached. Dow Jones's Martin Essex has the latest market news. Photo: AP

But the happy outcome owes much to mere chance. It masks flaws in the contracts, say some market participants and legal experts, that have rattled investors and are leading to calls to revamp how the swaps are handled for defaulting sovereign nations. Credit-default swaps, or CDS, are insurance-like contracts designed to pay off when creditors aren't paid back.

The issue arises because Greece used so-called collective-action clauses to force a debt exchange on the vast bulk of its bondholders. It gave a package of new securities to its creditors and then tore up the old bonds.

The use of the clauses throws a wrench in the process of determining the size of the payout owed to CDS holders. Usually that payout is determined by the value of the defaulted, old bonds. But, in Greece's case, those bonds have been vaporized. And the new bonds creditors received in the restructuring are only a small part of a package that includes high-quality bonds issued by the euro zone's bailout fund. A new bond thus isn't a one-for-one replacement for an old bond.

That leaves potential uncertainty about the amount the swaps will pay.

The credit-default-swap rules are "frankly kind of ambiguous," said
Leigh Fraser,
a lawyer who represents hedge funds at Ropes & Gray in Boston.

Collective-action clauses are becoming more popular. Euro-zone countries are phasing them in, and the Greek precedent has established that a country can unilaterally insert them in the bulk of its bonds.

By happenstance, some of the new bonds Greece has issued in its restructuring have a market price close to the total value of the package creditors received—about 22 cents on the euro. Those bonds will help set the CDS payout, and trouble will be averted: CDS holders will receive about 78 cents, roughly equivalent to the loss bondholders suffered.

"You can't be certain that this happy coincidence will happen next time," said
Tess Weil,
a lawyer at Purrington Moody Weil LLP in New York who represents hedge funds and other "buy-side" clients. Ms. Weil said she expects the issue will spur a "push to revisit" the CDS rules.

If the new Greek bonds had different terms—higher or lower interest payments for instance— their prices could be substantially different, changing the amount the default swaps would pay.
Ben Heller,
a portfolio manager at New York hedge fund Hutchin Hill Capital, which owns both Greek bonds and CDS, said that means the swaps aren't doing their job. He said that until the problem is fixed, he "will not use CDS as a hedge against credit exposures anymore."

ENLARGE

In a statement issued in response to questions about the swaps' payout,
Robert Pickel,
chief executive of the International Swaps and Derivatives Association Inc., the trade body that oversees CDS, didn't directly address whether the rules should be changed.

But he noted the rules and process for executing them have "evolved over the past 15 years to reflect changes in market dynamics and practices." He added, "We will work to further refine and strengthen this effort."

Credit-default swaps are an integral part of modern financial machinery. They permit lenders to hedge the risk of a borrower's defaulting, and they allow speculators to make bets on the credit-worthiness of a vast range of borrowers.

In theory, a creditor holding €100 of Greek bonds and €100 of CDS protection should lose nothing in a restructuring. That investor "would expect to be able to be made whole," said Ms. Weil. "Generally, that's the way the product is intended to work." At the most basic level, a CDS can be settled "physically" after a credit event like a debt restructuring or a failure to pay back principal.

A creditor with €100 in face-value bonds and €100 in CDS protection simply hands in the defaulted bonds and receives €100 from whoever sold him the swap. But not every CDS holder has the same quantity of bonds and swap contracts. Indeed, a swap holder may have no bonds at all; those holders are paid cash. Because the contracts cover the difference between the reduced value of the defaulted bonds and their full face value, it is necessary to figure out what the defaulted bonds are worth.

To do so, swap dealers hold an auction, saying at what price they would be willing to buy and sell the defaulted bonds. The auction result sets the payout on the swaps; if the old, defaulted bonds fetch a price of 40 cents, for instance, the swaps will pay out 60.

ENLARGE

Greece used so-called collective-action clauses to force a debt exchange on the vast bulk of its bondholders. It gave a package of new securities to its creditors and then tore up the old bonds.Above, an EU flag flies beneath the Parthenon temple on Acropolis hill in Athens earlier this month.
Bloomberg News

The auction for Greece will be held Monday. But Greece has already exchanged more than 80% of its old bonds in circulation, so there is little left to auction but some odd bonds issued under foreign laws, whose holders Greece couldn't compel to participate in the exchange.

And the prices of those bonds don't necessarily reflect what was lost by the holders of standard Greek bonds.

The panel of market participants that runs the auction is permitting the new bonds Greece issued in the exchange to be used. The price of the cheapest new Greek bonds, which Friday were trading around 22 cents on the euro, indicates roughly where the auction will settle.

The holders of old Greek bonds received compensation valued at about 23 cents in the bond exchange: 15 cents in high-quality bonds from the euro-zone's bailout fund, and 31.5 cents in new Greek bonds that, because they trade at about a quarter of face value, are worth eight cents.

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